RATIOS MOB

Ratio analysis Just inspecting financial statements may be of limited value, especially when there are certain key decisions to be made. Seeing a group of figures may not be as effective as using percentages and ratios to make comparisons from year to year. For example, if you are given the data in Table 15.1, what conclusion could be drawn? Is it simply true to say that Firm B is more profitable than Firm A or can we say that Firm A is underutilising its resources? In fact, we cannot draw any meaningful conclusion from the data given. Firms Firm A Firm B Net profit $20m $40m Table 15.1: Net profit figures for analysis If we add the following data to the table: sales for Firm A = $40m and sales for Firm B = $120m, which firm is now more profitable? This information can now be ascertained by calculating the percentage of sales that goes toward profit. The end result would see Firm A being more profitable than B, with 50 per cent and 33.3 per cent respectively. As a result, ratio analysis gives senior management and other stakeholders a better picture of the business’s performance over a given period of time. The ratios that are calculated will foster comparison of: The business’s performance with that in previous years Budgeted and actual performance or targets for the f inancial year The business and other businesses of the same nature in the industry. While accounting ratios are good, it should not be misconstrued that analysis ends with the calculation and comparison of these ratios. The figures and the comparison thereof may just highlight trends in the final accounts of the business. However, interpretation and analysis of these accounts lie in the reasons given for the trends and features identified by doing ratio analysis. Advantages of ratio analysis Provides the framework and information to compare a business’s performance with other businesses in the same industry or of the same nature 160 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Can produce vital information about the performance of the firm A good tool to use to assess the financial position of the business Can be used to identify possible weaknesses within a business which would not have been detected from simply drafting final accounts Helps management to formulate future plans and policies regarding the firm Can be used as a guide in making investment decisions Gives meaning, clarity and perspective to the accounting data presented in the final accounts. Limitations or disadvantages of ratio analysis Ratio analysis is predominantly quantitative and hardly focuses on quality, customer service and the morale of employees Ratio analysis focuses on historical data, with little emphasis on the future, though it can be used to make projections Any ratio that is calculated is only as accurate and reliable as the information that was used in its calculation – that is, if the financial report is not credible, then the ratio cannot be either Its usefulness is dependent on the skill of the user. It requires experience to interpret properly and place in context Ratios can only be used to compare similar companies and present with previous data If the ratios are not adjusted for inflation, they might be misleading. Types of ratio There are a number of ratios that are available to accountants. These are grouped into five categories: Profitability ratios or performance ratios – these measure how well the business is doing in terms of profit, turnover or sales and capital employed. They reflect the performance of the company and management Liquidity ratios – these show whether oor not the company can effectively pay its debt. They also reflect the firm’s short-term strength or solvency Investors’ ratios or shareholders’ ratios – these measure the returns on the capital invested by shareholders or other investors. They also show the relationship of ordinary shares and their price to the profits, dividends and assets of the company. Efficiency ratios – these measure how efficiently resources are utilised. They also determine the efficiency of the firm in collecting its debts Financial ratios or gearing ratios – these ratios assess the financial structure of the business, including the proportion of its financing that is obtained from debt capital.